What is Collateral in Crypto?
Collateral is security for a debt – an asset that secures a loan to protect the borrower's interests. With the advent of DeFi, which removes central entities and introduces permissionless financial services, including lending, collateral is needed to secure loans within the ecosystem. Collateral in crypto can range from stablecoins and other cryptocurrencies to liquid staking derivatives and NFTs.
Key Takeaways
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Liquid Staking Derivatives will likely become the next dominant DeFi collateral primitive.
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The current leading collateral in DeFi is short-dated United States Treasury Bills. Still, the space shows an increasing appetite for decentralized alternatives and a growing desire for more crypto-native collateral.
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A new wave of decentralized stablecoins has hit the market, supporting liquid staking derivatives as collateral and NFTs have become an established form of collateral, setting the stage for an expansionary phase for crypto-native collateralized lending services.
Lending has driven the vast majority of economic growth: it rests at the heart of the legacy financial system. Over-collateralization has become the salient method for obtaining loans in DeFi. And lending within DeFi has become one of the dominant applications for digital assets, given it allows lenders to earn interest payments and borrowers to increase market exposure/ put capital to productive use.
DeFi has one huge and often underlooked advantage over TradFi, summarized by the adage: ‘Standing on the shoulder of giants.’ DeFi builds on everything that TradFi has accomplished up until now, and given the prevalence of lending throughout human history, DeFi had plenty to build on and improve.
This article explores the nature of collateral within DeFi and the growing appetite for crypto-native collateralized products.
A Brief History of Collateral and Lending
Lending has underwritten human and economic development for thousands of years. Sumerian temples developed the practice of loans and credit. One of the earliest codified examples of lending comes from the Code of Hammurabi – a Babylonian legal text composed in 1755-1750 BC that discusses interest rates and other lending components.
TradFi primarily has two types of loans: secured loans underwritten by collateral and unsecured loans such as credit cards secured by the bank’s perception of the user’s creditworthiness. In DeFi, the former has become dominant. Although unsecured loans exist in DeFi, such as flash loans, most users will only leverage secured loans accessed via collateralizing crypto.
The most prolific example of collateral and a secured loan encountered by the majority is a mortgage. When a person takes out a mortgage, the house collateralizes the loan. The bank will repossess the home if someone fails to pay their mortgage. The house, as the collateral, protects the bank’s interests and secures their loan in case of default.
Ray Dalio states that credit is the economy's most important and least understood component. He believes it to be the most crucial element because credit is the economic machine's largest and most volatile part. Credit in TradFi mirrors the overall design of the fiat monetary system – intentionally confusing to discourage thorough inspection and keep the confidence game running.
The fractional reserve system leads to an elastic money supply, with banks creating money every time they make a loan, which is then deposited in other banks, and any money above the mandated reserve is lent out again, which is then deposited, and again lent out. Luckily, this article pertains solely to secured loans and collateral, the more concrete side of lending.
Lending in DeFi
Lending in DeFi on the surface level presents a more honest and less complicated version. Users deposit an asset and can borrow against it up to the protocol’s LTV (Loan to Value) ratio. Borrowers pay interest fees for borrowing – typically supply driven – and these payments go to lenders who supply the assets. However, the volatility of crypto makes the process slightly more dangerous. If users borrow aggressively and the price of their collateral decreases, they will be liquidated – more on this later.
MakerDAO, or more commonly, Maker, mints the over-collateralized and fully decentralized stablecoin DAI – one of the most prominent DeFi protocols and a perfect example of a crypto-native lending service.
Maker is permissionless, entirely governed by smart contracts, and allows anyone to take out a loan whenever they want as long as they have collateral. Users obtain DAI through Collateralized Debt Positions (CDPs) – users lock their assets in a smart contract, and when the DAI is repaid, the collateralized asset is returned.
Why is Lending Popular in DeFi?
The supply side: Lending protocols provide an excellent source of passive income for asset holders who want to generate yield on their holdings. Users face no risk of impermanent loss, allowing them to capture all the upside potential. Additionally, protocols typically pay out lending rewards in the supplied asset, offering an excellent way for investors to build their stack.
The demand side: Increased market exposure. Traders often use lending protocols to leverage their exposure to an asset, and more broadly, this has become the most prominent use amongst investors. Users can deposit assets, access liquidity without triggering a taxable event and continue to benefit from long-term price appreciation whilst accumulating more crypto. Crypto is also full of arbitrage opportunities, so if a user can borrow an asset at an APY of X and find a yield opportunity with an APY of Y, and Y>X, it’s free money.
As DeFi develops, the potentials grow increasingly exciting, with looped/ leveraged lending, alternative collateral unlocking new liquidity options for digital assets such as NFTs, and staking derivatives introducing layered earning.
Collateral in Crypto
The most prominent form of collateral in crypto may surprise investors: United States Treasury Bills.
USDT, the dominant stablecoin within crypto, is collateralized primarily by short-dated US Treasury Bills.
Similarly, the attestation for Circle’s popular stable USDC shows that the majority of collateral guaranteeing the value of USDC comes from short-dated US Treasury Bills.
Binance has increasingly relied on TUSD after regulators halted Paxos from minting any more BUSD, effectively putting the token into legacy mode with a down-only total supply. Based on the TrueUSD Holding Report, TUSD is collateralized by “USD cash, cash equivalents and short-term, highly liquid investments of sufficient credit quality that are readily convertible to known amounts of cash.” Aka short-dated Treasury bills.
GUSD, a stablecoin from Gemini, is again significantly collateralized by US Treasury Bills.
This reliance on US Treasury Bills spills over into other stablecoins in second-order effects. FRAX, a popular stablecoin – formerly algorithmic but moving towards a 100% collateralization ratio after the community voted passed FIP-188 – partially relies on USDC, as does DAI. So indirectly, US Treasury bills also collateralize these stablecoins.
The past year has been excellent business for these centralized stablecoin issuers. As the Federal Funds Rate rapidly rose – at the time of writing above 5% – interest payments have thickened the coffers of these centralized providers. Tether recently announced it had made $1.48 billion in profit and decided to use some of these profits to buy bitcoin.
The market remains split over this announcement. Increased risk due to a lack of transparency and no custodian heightening the risk of fraud? Or tremendous recurring buy pressure pumping everyone’s bags?
Stablecoins and the Hidden Issue of Centralization
When USDC depegged in March following the collapse of Silicon Valley Bank – where Circle, issuer of USDC, held roughly $3.3 billion in deposits – DAI, USDD, and FRAX also depegged, making their reliance on USDC clear to the crypto community. Since the crisis, these protocols have undertaken measures to reduce their exposure to USDC; however, this event perfectly illustrates the hidden centralization issue that plagues DeFi. The composable nature also shows; when there is an incident, this crisis always spills over and is never contained – otherwise known as contagion.
Stablecoins have allowed DeFi to flourish, providing a stable store of value in a volatile environment. However, the dominant trend has been a flight toward centralized stablecoins that command the lion’s share of total market capitalization.
It seems an oxymoron that centralized stablecoins have prevailed in decentralized finance. They have become dominant because they are perceived as reliable – subject to regulatory oversight – and, especially in the case of Tether, which entered circulation in 2014, have endured innumerable stress tests. The business model of stablecoins has also proved very profitable; they provide a stable store of value and clip coupons.
But a growing movement has been established favoring decentralized alternatives that will be explored later in the article. An interesting concept would be a US-Treasury-backed yield-generating stablecoin. Currently, USDC offers a stable store of value, and Circle takes 100% of the interest payments generated by the treasuries. Imagine if this yield went to the stablecoin holder, and in DeFi, this novel type of financial instrument is entirely possible.
But here comes the tradeoff between centralization and service. Decentralized yield-bearing stablecoins already exist, leveraging the supplied crypto collateral to generate yield on the back end. But accessing a stablecoin that distributes yields from US Treasuries would likely require a centralized component.
DeFi Native Collateral
ETH is the undisputed king of DeFi collateral. And not only within the Ethereum ecosystem but across multiple chains. Typically in any Layer 1 ecosystem, there will be two dominant sources of collateral, the native asset and WETH.
In DeFi, $1.7 billion of ETH has been collateralized to access loans. Liquidations levels can be seen, and immediately obvious is how little leverage there currently is in the space. This is typical fiscal behavior of a bear market; all the leveraged players have already been washed out.
Source: DeFiLlama
ETH has become the dominant form of collateral due to its relative stability when it comes to price. Due to this, protocols offer high LTV ratios for ETH compared to other assets, allowing users to squeeze more equity out of their holdings – further cementing ETH’s position as the king of DeFi collateral.
The rapid evaporation in value from native tokens – FTM, AVAX, SOL, and others – wreaked havoc within their respective ecosystems as liquidation cascades began when markets turned sour in 2022.
A Quick Note on Liquidations
Liquidations remain a central revenue generation model for DeFi lending services, and any investor holding a lending protocol token likely benefits financially from liquidations.
Given crypto’s volatility, the space has witnessed numerous mass liquidation events. Arguably the most famous was the Three Arrows Capital liquidation in June 2022.
In just over a week ETH’s price declined roughly 50% as a mass sell-off began with bad debt rippling through the ecosystem. It marked the macro low for ETH and caused a liquidation cascade.
When the collateralized asset loses value and is insufficient to cover the debt, the protocol will partially liquidate the asset to cover a portion of the debt, and this sell pressure can create death spirals by pushing other loans into the liquidation zone as observed in June 2022. This event starkly illuminated the inherent contention between collateralized loans and volatile assets.
However, this brutal liquidation event benefited DeFi long term, and governance proposals swept across the space with reductions in LTVs and a narrowing of the types of collateral accepted. Again, ETH was a net beneficiary of this movement as a collateral asset – the flight to safety always benefits assets with the lowest risk perception. Despite the savage price action, this event was vital in solidifying ETH as the dominant DeFi collateral asset, as counterintuitive as it sounds.
The release of protocols such as EigenLayer will further cement ETH’s place as the base collateral across crypto for security as well as economic activity. EigenLayer is an ETH-restaking service that allows other protocols to rent security from Ethereum via users restaking ETH and taking on additional slashing penalties in return for extra yield. ETH is becoming the internet bond. For the first time, ETH staking has exposed ordinary investors to the base financial layer.
The Demand for Crypto Native Collateral
The USDC depeg, the contagion to other stablecoins, and the general aversion to centralization that thrives in crypto have naturally led to an increased hunger for fully decentralized and trustless primitives. And in its current stage of adoption, crypto can support such services. As market caps have expanded, volatility has decreased in intensity, allowing the creation of more stable crypto-native services.
Liquid Staking Derivatives: The New Collateral Primitive
DeFiLlama shows that Liquid Staking services have attracted over nine million ETH. These LSDs (Liquid Staking Derivatives) search for yield or use within DeFi, and LSDs represent the new collateral primitive. With a TVL of close to $18 billion in dollar terms, that’s a lot of liquidity looking for use.
Source: DeFiLlama
Hence the principal goals of developers in the current meta revolve around integrating LSDs into existing protocols or providing a higher base yield on LSDs. Welcome to LSD summer. Liquidity defines narratives, and there is no larger source of capital in DeFi currently.
A moment to appreciate that users can earn staking rewards through LSDs, while simultaneously using them as collateral to access additional capital, and in the case of LSDs on Layer 2s, do all of this without paying extortionate gas fees. This level of capital flexibility and layered earning simply does not exist in TradFi.
The LSD Thesis
The next king of collateral in DeFi will be LSDs. The ability of LSDs to act as a base collateral asset possessing a yield-generating component makes them excellent primitives.
A staked derivative offers quasi-identical price stability with the additional benefit of yield denominated in ETH. The validity and plausibility of the thesis will be outlined by disproving its two central critiques.
First and most profound counter: Smart Contract Risk. LSDs come with smart contract risk, as does any non-native crypto asset. This smart contract risk increases as more moving parts are added. For example, wstETH holds more risk than stETH, the additional steps being a wrapping feature.
But any asset holds risk. Stablecoins like USDT present centralization and banking risks, fiat carries inflation risk, and even TradFi’s safest asset bonds come with rate risk, as many banks have discovered this past year. Investors need to understand their own risk tolerance and make decisions in line with this.
In reference particularly to derivatives from protocols like Lido, Frax, and RocketPool, which have already undergone strenuous auditing and battle-testing. Their continued existence without exploitation offers concrete proof of their security. Not to say they will not be exploited, but the longer they go without an exploit, the lower the possibility of an exploit occurring becomes.
Lido’s stETh and wstETh exist at the front of the pack for three reasons. First, perceived security due to possessing the largest market share. Second, first-mover advantage. Third and most important, integration. Lido’s LSDs have become the most integrated primitives in DeFi, leading to a positive feedback loop. More use cases for stETh & wstETH in DeFi naturally make these tokens more desirable.
The second critique. Lower LTVs for LSDs versus ETH.
Above are the respective LTVs for ETH and wstETH on Radiant, the predominant lending protocol on the Arbitrum network. Radiant offers users who supply raw ETH a 10% greater LTV than those who supply wstETH.
For a user looking to gain as much market exposure as possible over a short window, ETH offers a superior collateral asset. But for an investor with a long-term conviction in ETH’s value who has been holding an LSD throughout the bear market soaking up staking rewards and wants to increase market exposure, wstETH offers the better collateral asset for overall portfolio growth.
Given the volatility of crypto, borrowing up to the limit of LTV is foolish and an invitation to be liquidated, hence to be avoided. As LSDs become further integrated, protocols will likely change these parameters, perhaps with more weight on the scales in favor of LSDs.
A special note on how wstETH massively widened market possibilities: A weakness unique to stETH regarding DeFi integration is its rebaseable nature which many DeFi protocols cannot support; wstETH introduced a solid token spurring another wave of DeFi incorporation for LSDs.
LSDs As Collateral: On-Chain Data
Within five months, the total supply limit for wstETH was reached on the Ethereum network for Aave V3, and similarly, the total supply has been reached for wstETh on Optimism and Arbitrum.
DeFi Mochi's Dune dashboard for Radiant Capital shows that since April, supplied wstETH went from $5 million to $18 million. ETH, in terms of total value locked, still dwarfs its staked derivatives on Radiant, but when observing the game from a momentum perspective, LSDs look far more robust.
The Newest Decentralized Stablecoins: crvUSD, ERN, eUSD
Curve Finance specializes in AMM (Automated Market Maker) pools with assets that behave similarly, aka stablecoins. It recently launched its own stablecoin, crvUSD, with several intriguing features, such as its soft liquidation process, where collateral can be recovered if its value increases. When a position enters soft liquidation, the underlying collateral is swapped into crvUSD, and if it increases in value, swapped back to the supplied asset.
crvUSD is still in its beta and can only be minted with sfrxETH at this time.
Expect supported collateral types to increase, with LSDs featuring prominently. sfrxETH was selected for testing because it possesses a compatible oracle, and crvUSD’s use of banded collateral relies on oracle feeds. The Curve DAO should begin voting on new collateral soon. Impressively crvUSD has traded within a tight range of less than 0.5% since its inception.
Byte Masons have been busy shipping, and Ethos Reserve mints ERN, a decentralized yield-bearing stablecoin. The protocol charges a 0.5% issuance fee in lieu of interest payments, meaning Ethos Reserve facilitates interest-free loans.
It leverages low collateral ratios (108% ETH and 120% BTC) and uses these assets to generate yield for ERN holders. Users deposit ERN in the stability pool to receive this yield, and it currently offers 23% APR – not bad for an asset pegged to the US dollar.
eUSD from Lybra Finance introduces a yield-bearing stablecoin supporting LSDs as collateral and has recently crossed $180 million in TVL (Total Value Locked). The protocol essentially takes the yield component from LSDs and distributes it to eUSD holders.
The success of a stablecoin primarily comes down to two things: its ability to maintain its peg and its integration across the ecosystem. crvUSD, ERN, and eUSD remain in their fledgling stages, making it difficult to judge them. Crisis events are the best stress tests for stablecoins; none have endured one yet. Still, these will likely become pivotal players in the growing yield-focused decentralized stablecoin narrative.
The coming meta will be using a yield-bearing asset as collateral to mint a yield-bearing stable asset. Welcome the era of programmable money.
The Rise of NFTFi
As liquidity has thinned out in DeFi, protocols and users have become more imaginative with capital options. An enormous breakthrough for NFT holders was the integration of NFTs as collateral for loans.
These secured loans work the same way as those in TradFi with the NFT securing the borrower’s interests. However, these loans have far more flexibility, especially on the leading platform Blur. And even Binance has recently released ‘‘Binance NFT Loan,’’ which will support blue-chip projects like Bored Ape Yacht Club, Mutant Ape Yacht Club, Azuki, and Doodles for ETH-denominated loans.
This service only rolled out last week and ostensibly will integrate more collections in the future. Binance is incentivizing aggressively, with interest rates of just 3.36%, with relatively generous LTVs.
This centralized service competes with the decentralized leader Blend, the NFT lending service from Blur, which currently owns more than 80% of the total NFT lending volume since its launch in early May.
Blend allows users to set interest rates and create fully customizable loans with their desired terms. The default loan setting has no expiration, and rates remain fixed throughout the duration of the loan. Repayable at any time, Blend has introduced an excellent new service for NFT owners, strengthening the conceptual idea of NFTs as collateral.
On-chain metrics show the rapid increase in lending volume along with what could be a macro bottom for NFT floor prices. The NFT lending narrative looks like a great bid in the coming months.
Source: Nansen
Maturity and Crypto-Native Collateral
The central critique of crypto-native collateral is volatility. Crypto is a risk-on asset prone to sharp corrections, which can cause liquidation events. And given the composability of DeFi, these incidents always spill over into the broader ecosystem. However, this critique had far more weight in the last cycle.
As crypto assets mature, prices – yes, still volatile from a TradFi lens – become more stable, and this makes them better suited as collateral. On top of this, many DeFi lending protocols have introduced siloed pools meaning bad debt is contained.
This fundamental need for bolstered price stability also informs ETH’s consolidation as the leading collateral asset; which, if the LSD thesis plays out, will eventually be replaced by its yield-bearing brothers.
Crypto-native collateral, especially collateral with yield-bearing components, allows for more exciting loan provisions and even the creation of discounted assets or self-repaying loans. The rise of yield-bearing stablecoins illuminates only a fragment of what the future holds.
Lending within DeFi is already a multi-billion dollar market. At their current stage of development, crypto assets have enough liquidity and price stability to form a practical base collateral for a stable and robust lending industry. The demand for and output of crypto-native collateral and products will grow. And these services will inevitably deliver new ways for crypto investors to access the two things they love most, yield and leverage.
Kofi J has been active in DeFi since the 2020 summer explosion and has been rugged more times than he can remember. He hopes to make the decentralized economy a little bit more accessible through his prose. Follow the author on Twitter @k_pangolin
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